Fed's Credibility Tested as Inflation Drifts Below Target

With the U.S. inflation rate about half of the Federal Reserve's 2.0% target, the central bank is facing a major test and some experts wonder whether it will eventually need to ramp up its already aggressive bond buying program.

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The Fed cut official interest rates effectively to zero in late 2008 during the financial crisis. Since then, it has bought more than $2.5 trillion in bonds to bolster an anemic economic recovery and speed up the decline in unemployment.

Despite those actions, its favored inflation gauge, the Personal Consumption Expenditures (PCE) price index, has fallen to a 3-1/2 year low of 1.0 percent.

Further, by the Fed's own forecasts, inflation is likely to remain short of the central bank's target for years.

"They say that they're going to set monetary policy in a way that ensures future inflation will be 2.0 percent," said Justin Wolfers, an economics professor at the University of Michigan's Gerald Ford School of Public Policy.

"Right now, they expect it to be lower than that, and unemployment to be unconscionably high, so the Fed's own framework says that they need to take more stimulative action."

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That could happen, if the drop in inflation persists.

"I'm very willing to defend the inflation target from the low side. If we say 2.0 percent, we should hit 2.0 percent," St. Louis Federal Reserve Bank President James Bullard told reporters last month.

COMFORT IN OTHER MEASURES

For now, however, Fed officials do not view the decline as a signal of a worrying deflationary threat.

At its policy meeting last week the central bank decided to continue with its $85 billion a month in bond purchases, and a statement announcing the decision offered no hint of panic.

In its statement the Fed stuck with a characterization of inflation as "running somewhat below" its target, a phrase it had been employing since December.

Officials have taken solace in the relative stability of inflation expectations, which are seen as a leading indicator of actual inflation.

The spread between Treasury notes and inflation-linked bonds, a measure of investors' inflation perceptions, has eased gradually this year to its lowest levels since last autumn. But it is still far above the lows seen in 2012, before the Fed launched its latest and third round of bond buying or "quantitative easing".

Indeed, a daily deflation probability gauge produced by the Atlanta Federal Reserve Bank that is based on bond market measures currently reads zero, a level unchanged since February.

Policymakers can also take some comfort from a growing gap between the inflation gauge they target and the more popular consumer price index. CPI inflation has been running at much higher rates which may suggest the decline in the PCE price index will prove transitory and turn around if economic growth picks up as expected towards the end of 2013.

While the PCE price index rose just 1.0 percent in the year through March, and its core counterpart was up just 1.1 percent, the CPI was up 1.5 percent and the core CPI climbed 1.9 percent. It is the biggest gap between the two core measures in a decade.

"The Fed may view the divergence between the two measures as indicating that worries about deflation are premature," said Tim Duy, a professor of economics at the University of Oregon. "If core CPI was trending down as well, the Fed would be more likely to conclude that their inflation forecasts should be guided lower."

EVERYWHERE AND SOMETIMES

The difference between the two indexes has been driven by trends in home and food prices, and differences in methodology.

The CPI uses a fixed basket of goods while the PCE price index allows for the prospect that consumers substitute goods as one product gets pricier - coffee versus tea is an example.

There are also differences in the way the two indexes define food. For example, the PCE price index includes food services in its core index. So a recent slowing in food services costs has affected the core PCE price index but not the core CPI index.

Housing, which plays a much bigger role in the CPI, is also a big factor. When home prices slumped between 2006 and 2012, CPI inflation dropped below PCE inflation but now the opposite is happening.

An array of signs showing economic growth slowing sharply as the first quarter 2013 drew to a close raised some alarm bells, and helped to squelch talk at the Fed about the bond purchase program.

Yields on the benchmark 10-year U.S. Treasury note slipped from just over 2.0 percent in March to a four-month low of 1.63 percent last week as investors' concerns on growth increased.

But a report on Friday showing employment growth running higher than expected, despite a tighter fiscal policy in Washington, helped temper any fears of a deflation risk and the 10-year yield has moved back up to 1.78 percent.

"I do not see a deflation threat in other inflation-related data like labor costs and inflation expectations, so that makes it less likely to cause concern," said Jim O'Sullivan, chief U.S. economist at High Frequency Economics.

The late monetarist economist Milton Friedman famously argued that inflation is "everywhere and always a monetary phenomenon."

But the current period of sub-target inflation is a reminder that other factors, like the federal budget, help determine how much money makes it into the real economy.

If economic growth picks up later this year as the impact of austerity in Washington fades, as many economists expect, than the Fed's inflation gauge is likely to follow.